Brian Ashcroft

Debt

16 February 2012

The Centre for Economics and Business Research (CEBR) suggests in an analysis of the scale of subsidy between different regions/countries in the UK that Scotland receives no net subsidy. The table showing estimated receipts and expenditures is here

CEBR provide no indication of the sources of their data, or their method of estimation. However, their estimate for Scotland appears to be close to the Government Expenditure and Revenues for Scotland (GERS) figures for the net fiscal balance when Scotland is given a geographical share of oil revenues. The table below shows it was -10.6% in 2009-10.

Since the UK had a deficit in 2009-10 of 11.1% of GDP the conclusion drawn by CEBR appears, on the face of it, to be correct.

But wait. If independent, Scotland would have to pay interest payments on its debt at a rate which will almost certainly be above the yield on UK Treasury's, see my posts here and here. The GERS publication shows Scotland bearing interest payments on its population share of UK debt of £2.635 billion. This relates to UK debt payments at an average interest rate of 3%, given earlier more costly borrowing than the current 2% yield and the different maturities comprising the debt portfolio. If we make the assumption that Scotland would have to pay a yield on its borrowings that average 4%, then the Scottish government outlays would rise by about £1 billion - specifically £931 million. If the yield had to be 5%, outlays would rise by £1.8 billion. If 6%, unlikely, then the additional expenditure would amount to £2.7 billion.

So, even a modest premium above UK Treasuries, equivalent to the current yield on New Zealand 10 year bonds, would cost approximately an extra £1billion a year compared with present estimated Scottish government spending in GERS.

Bang goes that £1 billion surplus of oil revenues that Alex Salmond believes he could put each year into an oil fund!

15 December 2011

"It is this Government who have got interest rates down to 2%—that is why we have the prospects of growth."

What the Prime Minister was presumably suggesting was that the current low yield on Treasury 10-year bonds is the consequence of the Coalition government's programme of fiscal consolidation. The aim of this policy is to reduce the large structural budget deficit, which is leading to higher levels of government debt. So, the UK government argue that the willingness of the financial institutions to lend to the British government has been enhanced by the programme of cuts in public spending and some tax rises. Ministers often contrast Britain with Greece, or Italy, suggesting that if we don't continue with the programme of fiscal consolidation our debt level will remain high. A continuing high debt level, they argue, will lead to the market flight and high bond yields currently observed in those two countries. The high long-term bond yields would, in turn, divert large amounts of public spending from socially and economically productive uses into interest payments on the debt. They may also raise the borrowing costs for private sector investment, so dampening investment and growth.

Is the government's view correct? Has fiscal consolidation led to a lowering of bond yields? And, more generally do high levels of government debt lead to high bond yields?

The first chart shows the path of 10-year UK Treasuries since 2007.

What is clear from the chart is that UK 10-year yields have been falling since 2007? Why? Probably because of the weakening of growth in the economy. When the financial markets expect low growth and low inflation, they tend to move out of equities and into fixed interest securities or government bonds. Government bonds act as a safe haven in time of economic trouble. The chart does show a fall in the yield during 2010 and some of that might have been due to the fiscal consolidation plans of both Labour and then the Coalition government which came into office in May 2010. But from the third quarter of the year yields began to rise again until the first quarter of 2011 as expectations of economic recovery rose. After the first quarter the 10-year yield began fall fairly quickly. But this fairly clearly was not due to fiscal consolidation, because there were no new announcements. Indeed the signs were that the UK economy was slowing and that there was an increased risk of failing to meet the deficit and debt reduction targets.

Two things were happening. First, economic growth was slowing across much of the developed world and secondly, the Eurozone crisis began to worsen. The ECB pushed interest rates up in April and again in June, both decisions were viewed by many economists as mistaken because the inflation risk was negligible. The interest rate rise increased the risk of a slowdown in growth in the Eurozone and hence increased the attractiveness of government bonds. Moreover, the risk of liquidity and solvency problems in Greece, Portugal, Ireland and Italy meant that a self-fulfilling flight was beginning away from peripheral country Eurozone bonds.

But is it legitimate to argue that just as there was a flight away from peripheral Eurozone bonds, so there would also have been a flight away from UK government bonds if the markets expected UK debt levels to remain high? In other words, while low growth may lead to financial markets switching away from risk assets such as equities towards government bonds would they only switch to bonds of countries where the debt was low, or was falling?

The answer to these two questions is, no! The reason is that the risk of insolvency is appreciably greater in countries with high levels of government debt and where borrowing is effectively in foreign currency and there is no own central bank. In countries such as the UK with their own currency and central bank, the central bank acts as a lender of last resort and can also print money to pay creditors. This may, through the risk of higher inflation, reduce the potential real value of the debt to the creditor and that is likely to be preferred to a complete default.

So, for countries with their own currency and central bank we should expect that there is little or no relation between government debt levels and bond yields. This is what the data show as indicated by the next chart.

The non-Euro countries are in black and there would appear to be no relation. There is something of a positive relation between debt level and bond yields in the peripheral Euro countries but nowhere else.

We can therefore conclude that there is little evidence to support the UK government's contention that fiscal consolidation has delivered low government bond yields and the prospect of greater future prosperity. Rather the imposition of an austerity regime threatens lower prosperity and only through that route a reduction in bond yields, while the reduced growth means that deficit and debt targets may fail to be met.